Summary - We anticipate a heightened level of uncertainty, especially geopolitical uncertainty, heading into the second half of 2024. While the upcoming elections in the EU and USA are primary concerns, additional factors clouding the outlook include developments within NATO, the EU, Ukraine, and Russia, as well as our concerns about market structure. Combined, these factors warrant a more cautious portfolio positioning. Therefore, it is prudent to take some gains and shift allocation to assets we expect will help the portfolio weather potential approaching storms.
Portfolio implications in our model portfolio include reducing risk exposure, resulting in an underweight allocation in DM bonds (underweight long duration, overweight short duration) and stocks, while still holding overweights in select EM markets. Our main overweight is now cash and gold. We anticipate holding onto our cautious positioning until the outcome of the elections is clear.
May 2024 Investor Letter:
Reducing Exposure - Election Risk & Rising Uncertainty
We expect general market uncertainty to rise and are particularly concerned about core DM markets given rising election-related uncertainty. Also of concern are DM bond markets, especially bonds historically considered “risk-free”. Several serious factors will weigh on this “risk-free” market, including geopolitical trends, regulatory demands, structural changes, secular inflationary pressures1 , and supply and demand dynamics. As for equities, valuations, policy uncertainty and risk-adjusted relative value also suggest it is time to derisk and lock in some gains.
Geopolitical Factors
Financial market participants may not fully come to terms with the complexity of our times. From social and demographic trends to historic geopolitical developments, geopolitical fragmentation, moving from globalization to a global trading system segmented into ideologically aligned economic blocks (IAEBs)2 . Add to this already complex backdrop the rapid pace of technological change, the growing frequency of extreme weather events, massive debt piles, sticky inflation and sticky rates through the “great transformation”.2
Undoubtedly, the world as we've known it for the past seventy years is undergoing a massive shift. I previously addressed this in a December 2021 publication, suggesting that the global economy and markets would likely experience forced, planned, and unexpected transformations in the years beyond 2022. The entire tapestry of our global systems and architecture is in flux, with uncertain outcomes. This great transformation is a secular phenomenon and will endure indefinitely until another super force alters the course of geopolitical direction. This represents new and unfamiliar territory for most policymakers and market participants alike.
To overlook the implications of the ongoing geopolitical transformation and its impact on global financial markets and investor capital flows would be shortsighted. While some speculate about the demise of the US dollar due to geopolitical developments, few consider the outlook for other US financial assets, notably the US government bond market, “the bedrock of the global financial system.”4
The recent US as well as NATO decisions and announcements about Ukraine, Russia, and China have been and continue to feed the geopolitical fragmentation which will continue to impact the flow of goods, services and capital. Governments that are not aligned with the NATO view of the world are many and sizeable. As geopolitical considerations increasingly impact investor decisions, sovereign asset managers will opt for assets perceived as less vulnerable to geopolitical tensions or assets that belong to countries better ideologically aligned with their view. Interest in the assets of NATO member countries may continue to wane and have a sizeable impact on markets, yield curves and economies. Unless there is an abrupt and major “about-face” and easing of pressure from NATO countries, term premia will be pushed, and rise considerably in the quarters ahead.
Now, on top of the mentioned geopolitical risks, the months ahead contain major elections with mounting uncertainty in the EU and especially in the US. These are not your ordinary elections. In both the EU and the US, tectonic shifts are taking place. Risks are elevated, including election tampering, interference, misinformation, and disinformation. The biggest risk, particularly in the US, is the further erosion of confidence in the US electoral and political system. When viewed from a global investor perspective, the attractiveness of both regions is increasingly worrying.
The EU 2024 Parlament elections are expected to “see a major shift to the right5 ” and as such having a more right-leaning EU will have an impact across all policy matters. Meanwhile, there is in our view a growing possibility that the Ukraine - Russia war will come to a close and while all sides will attempt to frame the narrative as a win for themselves, we expect the result will be a geographically smaller Ukraine. How this impacts NATO and the EU in general is difficult to predict, however, it is likely to have a negative spillover onto NATO and the EU as a whole. While there could be a relief rally, such an outcome could weigh on EU markets and currency over the longer term horizon.
Regulatory Demands and Structural Changes
Undoubtedly, most, if not all, NATO member countries will issue more debt. With increasing supply, possibly decreasing foreign demand due to geopolitical factors, and weaker, smaller dealer capacity, the risk of dysfunctionality in major bond markets is noteworthy and warrants careful consideration.
For the US bond market, the Basel III Endgame remains an open question. According to SIFMA, the “Endgame” package, if adopted, will “significantly increase banks’ capital requirements over-and-above their already historically high levels...resulting in significant additional funding costs for businesses, consumers and investors.”
In addition, coinciding with the potential adoption of the 'Endgame' requirements are market functioning issues related to size and structure. The size of the US Treasury market will continue to grow rapidly due to the US deficit and funding needs. However, the size of dealer balance sheets is not keeping pace. This should be a concern, as it suggests that the infrastructure of the US Treasury market may not be able to accommodate major activity triggered by risk events such as the upcoming elections." (see notes section for further comments)
The recent Fed Financial Stability Report (FSR) does list 'Treasury Market Strains and Volatility' as one of the most cited concerns, but we expect it to move higher in the risk ranking and become one of the top concerns in the quarters ahead (see image 1).
To monitor these risks in the bond market, we monitor multiple variables including the Bid-Ask Ratio, Bid-Ask Spread, bond market volatility measures (CBOE MOVE Index), credit spreads, convexity, and trading volume and keep a close eye on how the Basel III Endgame story develops.
Government Bonds - Supply and Demand
The S&P Global Ratings February 27 report, Sovereign Debt 2024: Borrowing Will Hit New Post-Pandemic Highs states “We estimate sovereigns’ long-term borrowing will reach $11.5 trillion in 2024, more than 50% above the pre-pandemic-levels, amid softer GDP growth, the heavy election schedule, elevated interest, and defense spending.”
The confluence of factors including the Fed's QT, rising inflation expectations, and geopolitical developments has heightened uncertainty in the US bond market, prompting investors to reassess their portfolio strategies and risk exposures just as supply is increasing. Demand may not be as robust, especially foreign central bank demand if the US elections are problematic and the US government continues to have problems agreeing on how to manage the federal deficit which in 2023 was $1.7 trillion, equal to 6.3 percent of gross domestic product. At the global level, the OECD 2024 Global Debt Report states “At the end of 2023, the total volume of sovereign and corporate bond debt stood at almost USD 100 trillion, similar in size to global GDP.”
With the growing supply of sovereign debt, quantitative tightening and reduced dealer demand due to increased regulation and capital requirements, the possibility of the developed market government bond market dysfunctioning is growing.
It’s best to consider stress-testing balance sheets and portfolios for sovereign bond market dysfunction, and increased market volatility and consider diversification options for what has traditionally been a core “risk-free” allocation.
Authorities, from central banks to ministries of finance or treasury offices must have a rapid response plan in place. Bond market dysfunction is a real and growing risk. If market liquidity does become impaired and the system begins to dysfunction, authorities must aggressively step in to ensure that stability is quickly restored, and a critical transition state avoided.
Tactical Asset Allocation Update – May 2024
From an asset allocation perspective, our model portfolio is moving from a neutral Equity allocation weight to an underweight. The weight from Equity is shifting to Cash, and Gold, again.
The move to risk-off is due to policy uncertainty having risen to uncomfortable levels across geopolitics, politics (local elections), fiscal and monetary policy. We are more concerned about the risks around the upcoming elections in the EU (June) and the US (November) than most market participants seem to be.
Charts below are from the Fed’s April FSR and are worth studying and contemplating. For US markets, we anticipate a steady increase in both the term premium and bond market volatility in the quarters ahead; not a constructive outlook for the US bond market. We remain underweight US fixed income in our model portfolio.
For US equities, we also turn to the Fed’s April FSR which states:
“Measures of equity market valuations rose further from already high levels. The ratio of prices to expected 12-month earnings, or the P/E ratio, increased since the October report and currently sits in the upper end of its historical distribution since 1989.
The difference between the forward P/E ratio and the real 10-year Treasury yield—a measure of the additional return that investors require for holding stocks relative to risk-free bonds (the equity premium)—declined, on net, since the October report and currently stands well below its historical median.”
As for US equity markets, we also can turn to the Fed’s FSR and while we consider P/E ratio and equity premium levels, while these metrics are more a work of art than science, we consider these as peripheral not a central variable in our decision-making process. When combined with other factors such as geopolitics, politics and the event calendar we find enough reasons to move the equity allocation to underweight.
Source: Federal Reserve Financial Stability Report April 2024
Monthly Tactical Asset Allocation - Client-only content
Monthly Major Currency View Monitor
Endnotes, Charts, Data, References -
Image 1 - Fed’s FSR April 2024 Survey of Salient Risks to Financial Stability shows persistent inflation and monetary tightening as a top risk over the next 12 to 18 months, policy uncertainty as the number two risk but treasury market dysfunction/basis trade risk at number six. This risk should move higher, and become greater in quarters ahead.
Image 2 - Fed’s FSR April 2024 has Total runnable money-like liabilities grew at 8.8% to $21.3 trillion. This is over the historical median and should be a cause for serious concern. Even more concerning is that the large banks are now sitting on a larger much larger share of uninsured deposits than one year ago. The term “Total runnable money-like liabilities" is used in economics and finance to refer to the sum of all liabilities that are readily redeemable on demand. These liabilities typically include bank deposits that can be withdrawn at any time without notice, as well as other short-term liabilities that function as money substitutes. The term is commonly used in the context of assessing the liquidity of financial institutions or the overall stability of a financial system.
Image 3. US bond market measure, the ICE (Intercontinental Exchange) Move Index, also known as the MOVE Index, measures the implied volatility of U.S. Treasury markets. It reflects the market's expectation of future volatility in the Treasury bond market over the next 30 days. The index is calculated based on the prices of over-the-counter (OTC) options on 2-year, 5-year, 10-year, and 30-year Treasury bonds. Generally, a higher MOVE Index value indicates higher expected volatility in the Treasury market.
Source: Yahoo Finance. The ICE Move Index, April 26 2024
Notes on US treasuries market structure - Beyond the election, in March 2025 the Securities and Exchange Commission (SEC) last December the adoption of rule changes aimed at bolstering risk management practices and encouraging additional central clearing in the U.S. Treasury market. These changes mandate covered clearing agencies to implement policies requiring members to clear specified secondary market transactions to reduce systemic risk and enhance market stability. The amendments are also expected to enhance risk management by requiring separate margin calculations for house and customer transactions and facilitate market access for indirect participants. The decision includes a phased implementation approach to mitigate disruptions and ensure smooth adaptation to the new regulatory framework, aiming to fortify the resilience and efficiency of the U.S. Treasury market.
The amendments will be implemented in two phases. Initially, changes related to the separation of house and customer margin, the broker-dealer customer protection rule, and access to central clearing must be completed by March 31, 2025. Subsequently, the requirement to clear specific transactions will be phased in, with cash transactions preceding repurchase transactions. Direct participants of U.S. Treasury securities central clearing agencies must comply with the requirement to clear eligible secondary market transactions by December 31, 2025, for cash transactions, and by June 30, 2026, for repurchase transactions. Not only will banks need to deal with a larger supply, but the market will have to deal with a new transactional infrastructure.
The SEC's central counterparty clearing rule changes aim to mitigate systemic risk in the financial system, however, they could also have unintended consequences such as concentration risk and reduced competition among clearinghouses. Mandating central clearing for certain transactions could inadvertently lead to market fragmentation if smaller market participants find compliance economically burdensome, thus reducing overall market liquidity and efficiency. Moreover, concentrating counterparty risk within clearing agencies may pose systemic risks, as any disruption or failure within these entities could have far-reaching consequences. Additionally, the inclusion of exemptions for certain transactions may create loopholes in the regulatory framework, potentially undermining the effectiveness of the SEC's initiatives.
The Great Transition will permanently change market functioning and authorities will become a regular and large market participant, ultimately, in the long-term becoming larger regular participants soaking up supply and moving bond market volatility down, likely to historic low levels. However, in the interim, from now until such a point in time, get ready for turbulence, stress, higher term premiums, significant bear steepening and increased market anxiety.
- Secular inflation is the new normal — Get Ready – Belal M Khan, August 2022, Geneva Management Group.
- Ideologically Aligned Economic Blocks (IAEBs) - A group of ideologically aligned nation-states and/or intergovernmental alliances which benefit from cooperation. Characteristics of IAEBs include the discriminate movement of ideas, people, goods, services, & capital. Structured, controlled integration, avoid/limit interdependence, ensure self-reliance. Preservation and fortification of the nation-state. All of this contributes to creating secular inflationary pressures. Belal M. Khan, November 2022, Geneva Management Group.
- The Great Transformation, December 2022, Belal M Khan
- Basel III Endgame Blog Series – Dr Peter Ryan, Managing Director and Head of International Capital Markets and Strategic Initiatives SIFMA
- Long Term Projections of Power: Political, Economic and Military Forecasting. By O. MORGENSTERN, K. KNORR and K. P. HEISS. (Cambridge, Massachusetts: Ballinger Publishing Company, 1973)
- Federal Reserve Financial Stability Report, April 2024
- S&P Global - Sovereign Debt 2024: Borrowing Will Hit New Post-Pandemic Highs, February 27, 2024
- OECD - Global Debt Report 2024 - Bond Markets in a High-Debt Environment
- US SEC - Press Release - Dec. 13, 2023 — SEC Adopts Rules to Improve Risk Management in Clearance and Settlement and Facilitate Additional Central Clearing for the U.S. Treasury Market
- US Congressional Budget Office
- Council on Foreign Relations - Preventing U.S. Election Violence in 2024, April 17, 2024
- The Rand Corporation - The 2024 U.S. Election, Trust, and Technology- Preparing for a Perfect Storm of Threats to Democracy - April 2024
Disclaimer: The information provided in this newsletter is for informational purposes only and does not constitute investment advice, financial analysis, or a recommendation regarding the purchase or sale of any securities or financial products. Readers are advised to consult with a qualified financial advisor or other appropriate professional before making any investment decisions. The content provided herein reflects personal opinions and views which may change without notice. Neither the author nor the publisher shall be liable for any errors or omissions in the content, nor for any actions taken in reliance thereon. All investments involve risk, and past performance is not indicative of future results.
